Property investing has its dark side and, though largely legal, there are some clever schemes a handful of unscrupulous property ‘gurus’ continue to run in a desperate attempt to rip you off
Yawn. Easily the most boring way to start an article like this would be to remind investors that something that looks too good to be true probably is, but we’re guessing you already know that.
Unless you share the intellect of a Big Brother contest, we bet you’re unlikely to be fooled by the obvious ploys out there. This would include your standard “you’ve miraculously won the lottery of some far-off, unpronounceable country” hoax to emails explaining how your bank details have been compromised – only you’re not part of that bank.
Far harder to detect are methods that spruikers use to legally cheat you out of money. And unfortunately property has its fair share of them. The trick they employ is not to use overtly deceitful schemes, but to hit you with the small print. They know the ins and outs of the industry well and are counting on the fact that you don’t.
What follows are four vehicles overly ambitious marketers have been known to push in the past – property investment opportunities that can make you money if you are extremely lucky, but are most likely to be of the type that deserve caution. Buyer beware.
- RENT-TO-OWN SCAMS
The concept: As the name suggests, renters are given the option to rent out a property, which they can at some point buy. The deal is orchestrated by a “wrapper” – a middleman between a seller and a buyer.
Legality: In most states rent to own deals are legal and not all are set up to be exploitive. The problem is that the idea tends to attract con artists.
Targets: Sellers facing difficulties getting their properties off the market and wannabe buyers who are struggling to get loans.
Figures involved: Victims can lose anything up to $150,000.
How it works: Wrappers typically source properties for these deals by trolling property listings and noting which aren’t selling. They approach these people with a new idea of how they can sell their home, offering to buy the property for the full asking price.
The catch is that they will only purchase under an option agreement, where the wrapper purchases an option (but not the obligation) to buy the property for a fixed amount at a certain date in the future, maybe within two or three years. The wrapper also gets the right to sublease the property to a rent-to-buy tenant.
As bait, the seller is offered above market rent for the term of the option, with all rates, water charges and insurance costs taken care of.
Once the wrapper has a property under an option agreement, he will typically start looking for a buyer – someone who is unable to borrow money from a bank or normal lending institution, but is desperate to own their own home.
They propose a solution to the wannabe buyer’s problem – rent to own. The buyer is told that he can purchase the property by paying an inflated price further down the line, when property prices will have apparently doubled anyway, and rent the property in the meantime.
The rental figure will be well above the market, but the buyer is told that half of it will go into a savings account to show a history of savings and the other half will be deducted from the purchase price when they eventually settle. The buyer is also told to pay all outgoings on the property.
The problem: (For the seller): For the existing owner of the property, a reasonable option fee for such a scenario would be if the wrapper forwarded a down payment of at least 10% of the purchase price. Playing fair, the longer the term of the agreed option, the bigger this option fee should be.
The option fee is designed to be the fee forfeited if the wrapper decides to pull out of the deal. If the wrapper goes ahead with the deal, the option fee will generally be deducted from the purchase price whenever the property is settled.
Property consumer researcher Steve Butcher warns that this is where things get ugly. “There are many tricks that a dodgy wrapper will play throughout the process,” he says. “I have seen examples where they only paid the sum of $1 for an option fee. He has turned up at the seller’s house armed with all their paperwork which he has rushed the seller into signing.
“Because the seller generally has little knowledge of how these deals really work, he signs the paperwork that is put in front of him, based purely on trust. The seller doesn’t understand what it means, but he trusts the wrapper.”
The problem (For the buyer): Meanwhile, the buyer who has been promised rent-to-buy also has little clue about whether this is a good deal for them. Their focus is on buying their own home and the wrappers are great at selling the positives of the deal while leaving out what can go wrong.
They fail to realise that all the costs of the deal between the wrapper and seller have been transferred to them. They’ll also have no idea that a deal exists between the seller and wrapper. “The wrapper will often simply refer to the seller as his silent business partner and the buyer is told they can only deal with the wrapper,” says Butcher.
Butcher says that the reason for this is simple. “It is only when the buyer and seller get together that they start figuring out how they are both being taken advantage of.”
What goes wrong: (For the seller): Because the agreement between the seller and wrapper is for an option fee of only $1, a lot of the wrapper’s risk is removed from the deal. If the wrapper runs into problems with the buyer later, he only has to pay the seller $1 to get out of the deal.
Although it is legal, it leaves the seller back at where he started, not out of pocket, but annoyed because he has wasted his time.
What goes wrong (For the buyer): He pays double the rent and outgoings on the property for, say, three years, but has no control over the property he is purchasing. Any money paid to the wrapper can potentially disappear if he defaults on even one payment or if he can’t secure finance on the deal.
Of course, because the buyer has also agreed to pay a purchase price that is already inflated, many buyers discover that two or three years on, the property is worth only marginally more than it was when they started the deal. Sometimes it is worth less.
That’s when they discover they have a problem. The bank won’t lend them money because the property is over-priced. (The bank knows that in a fire sale situation they would not recover the money they have lent.)
By the time the buyer realises he can’t get finance, the wrapper’s option agreement is about to run out and so the whole deal falls through. The wrapper retains all of the payments the buyer made (minus the rent he has paid to the seller). In the end, the buyer is evicted and left with nothing.
- ONSELLING HOUSE AND LAND PACKAGES
The concept: House and land packages are bought, not as an investment to hold, but with the intention of on-selling or trading the asset at completion date.
Legality: This nothing other than a bad idea.
Figures involved: Depends on the price at settlement, but the Australian average for the purchase of these packages stands close to $450,000, which the investor can easily lose a sizeable portion of.
How it works: Easy there, cowboy. There’s nothing wrong with buying a house and land package. What is dangerous is buying it under the belief that values will have increased so much by the time it is completed that you’ll be able to sell it for a handsome profit.
Metropole director Michael Yardney says it is quite easy to see why this is a bad idea. “There is no margin in house and land packages to allow for a trading profit. Price sensitive purchasers will go down the road and buy directly from the builder who can always sell properties cheaper than a middleman,” he says.
Yardney adds that even if you could sell, and for a higher price than all the other speculators who are doing the same in the same estate – after stamp duty and tax, you’d lose out anyway.
“Don’t be fooled into thinking these are the areas that will outperform over the next few years either,” Yardney says, pointing out that many of the areas where you’ll find house and land packages are in outer suburbs that suffer the most when interest rates rise.
“In the outer suburbs, people’s wages tend to go up [with inflation]. In the inner, more affluent suburbs, residents have greater disposable income that increases by substantially more than [inflation]. They often have businesses, shares, investments and they won’t be as worried by rising interest rates.”
- TRADING OFF-THE-PLAN PROPERTIES
The concept: The buyer sees blueprints or artist impressions of a property and buys it with the plan to sell before settlement, meaning he won’t have to come up with the full purchase price and can potentially pocket the capital growth on the property over the time it takes to be constructed.
Legality: Obviously, this is completely legal.
Targets: Investors looking to make big money by taking short cuts.
Figures involved: Those who foolishly engage in this activity look to inherit properties that could be worth less <keep italics> at settlement than at purchase time, eroding any chances of a profit.
How it works: A lot of off-the-plan properties these days are marketed by sleek property marketing companies. They work for the developers, who pay their commissions.
The developers gladly pay these fees to get as many of their properties sold as possible and quickly. They typically use very slick sales people who are not afraid to omit information that may be detrimental to a sale.
One of the things these companies promote is that the buyer can commit to buy off-the-plan, but sell before settlement. This means they don’t have to come up with the full purchase price. In the meantime, as they wait for the building work to be completed they benefit from the capital gains. This is all by using something as simple as a deposit bond.
Butcher warns that it an option fraught with danger. “The risk is if too many buyers all have the same strategy,” he says.
Butcher says that as a high supply of once off-the-plan properties in a development come onto the market their scarcity value goes. Now a dime a dozen, property values sink and the properties are worth less than their purchase price. Suddenly the prospect of even selling at the cost of purchase is gone and the buyer has two choices: sell and cough up the difference in their purchase and selling prices or settle on the property.
In the case of the latter, this may not be easy. “Many buyers have been forced to settle even though they may not have the ability to borrow the funds,” says Butcher.
- RENT GUARANTEES
Concept: To attract buyer interest, a seller or developer guarantees a certain rental return over a period of time.
Legality: 100%, but what few realise is that the guarantee is usually factored into the purchase price and that in most cases you’d be better off without it.
Targets: Investors looking for security against vacancies.
Figures involved: Up to $60k of your money could needlessly end up in a seller or developer’s pocket.
How it works: It’s become common for developers in Sydney, Melbourne, Brisbane and elsewhere to attract investors by guaranteeing 6% or 7% returns for one, two or three years.
The problem is that the guarantee comes at a cost. It is usually factored into the purchase price. Unknowingly, you pay the developer upfront for the rent he will repay you over the next few years.
Here’s an all-too-typical scenario of how many investors run into trouble: A developer has 100 units and needs to sell them for $400,000. This isn’t easy because the market is performing badly and their true value is more like $350,000.
The rental market will pay only $350 a week, which means that, for the $400,000 price, the investor’s return is 4.5%. Developers realise these numbers won’t attract investors – at least not in a hurry – so they put in place a rental guarantee.
They price the units at $400,000 with a rental guarantee of $450 a week for two years. This pushes the yield to 5.9% and suddenly investors are interested. To finance the guarantee, it costs the developer $100 a week to foot the difference between the guaranteed rent and what the market will actually pay. This totals $10,400 over two years, which would seem a lot except that, since the developer was paid $400,000 for a property worth only $350,000, he is still some $40k ahead.
The headache comes after the two years are up. When the guarantee expires, the investor has to find tenants in the open market. Upon realising that the market will only pay $350 a week, the investor’s returns fall from 5.9% to 4.5% in the blink of an eye.
It gets worse. If the investor wants to sell, the value of his property will have fallen because the returns have fallen. When he enters the selling market he will have to compete with developers selling new units guaranteeing a 6% return. The investor has to match that if he hopes to sell.
For more articles like this, visit www.yourinvestmentpropertymag.com.au